ACTIVISION BLIZZARD: What it all means

Vivendi will also purchase 63 million shares of Activision common stock for $1.7 billion, leaving the company with around 685 million fully-diluted shares outstanding. The new company (Activision Blizzard) will then tender $4 billion for up to 146.5 million outstanding common shares at $27.50 per share.

Vivendi has agreed to acquire another 24.5 million newly issued shares for up to $700 million in order to fund the tender offer, with the remaining amount of the tender to be borrowed. If the tender is fully completed, Activision Blizzard will end up with around 560 million shares, with just over two-thirds owned by Vivendi.

We estimate that the combined company will end up with around $400 million of debt, and will generate around $600 – 800 million in annual cash flow. Accordingly, we expect the company to end up with net debt of zero one year after the transaction closes, although we believe that it will be inactive on the acquisition front for another 18 months or so.

On first blush, the combined company will be a behemoth, with combined pro forma revenues of around $3.8 billion, a marketleadership position in MMOs with World of Warcraft, and with a formidable lineup of packaged products, including Guitar Hero.

Activision was well behind industry leader Electronic Arts in its development of an online gaming strategy, and the combination with Vivendi moves Activision from virtually no online presence to a market-leading presence almost overnight. The company has several franchises like Guitar Hero, Call of Duty and Tony Hawk that may be susceptible to online play, and a combination of Activision’s games prowess and Vivendi’s MMO know-how should allow the new entity to better exploit its intellectual property by selling subscriptions in Asia and the rest of the world.

We believe that World of Warcraft will continue to grow at a modest pace for several years (this contrasts with our early view that the game would peak at 4 million subscribers—it has 9.3 million at present), and we expect margins on the game to expand once the current distribution deal with The9 Ltd. expires in 2009. We have much work to do to be in a position to explain the structure of the current deal, but our understanding is that Blizzard has opened up Asian distribution of WOW to competitive bid, and any renewal of the deal should be at substantially higher margins in 2010 and beyond.

Accordingly, we think that the price “paid” for Vivendi Games (approximately 15x operating income) may end up being a bargain.

Activision expects the transaction to close in the first half of calendar 2008, and expects the deal to be immediately accretive to its shareholders. The transaction has been approved by both the Activision and Vivendi boards, and must be approved by Activision shareholders and by Federal and EU regulators. The company estimates that the combination will generate pro forma EPS in excess of $1.20 in calendar 2009.

We believe that Activision was on pace to generate around the same amount on its own, but note that the company currently has around 320 million outstanding shares, implying $384 million in net income, while the new company will have around 560 million shares, implying around $672 million in net income.

The new company will be called Activision Blizzard, and key Activision management will retain leadership roles. Activision CEO Bobby Kotick will remain CEO, COO Mike Griffith will remain CEO of the Publishing group, and CFO Thomas Tippl will remain CFO of the combined entity. Vivendi CEO Bruce Hack will become Chief Corporate Officer and Mike Morhaime will remain CEO of Blizzard. Jean-Francois Grollemund will transition from Vivendi CFO to Chief Accounting Officer of Activision Blizzard. Vivendi will control six of the 11 board positions, and current Activision Co-Chairman Brian Kelly will become Co-Chairman of Activision Blizzard.

We believe that the transaction should be viewed by investors as a merger of equals, with Activision operating management remaining in control of the combined entity, subject to oversight by the Vivendi board. We are generally positive on the combination, as we think it strengthens Activision’s product offering and expands its geographic reach, while allowing Vivendi to further monetize its success with World of Warcraft.

It is difficult to assess the potential growth of WOW, but we believe that Vivendi’s presence in Asia and market leading position in MMOs provides Activision with the potential to expand many of its games to online play.

Raising our price target to $30 from $27.50, but lowering our rating to BUY from STRONG BUY, primarily due to the limited upside from Monday’s likely closing price. We have little visibility into the earnings power of the combined company, and must accept management guidance.

Accordingly, we think it is reasonable to assume that Activision Blizzard will earn $1.20 in calendar 2009, and that its shares will be valued based upon a forward multiple applied to that figure. Our price target values Activision Blizzard at 25x calendar 2009 EPS, at the low end of its historical multiple range due to the lack of near-term visibility.

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